This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. Equity markets are volatile and an investor may ...

This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. Equity markets are volatile and an investor may ...

This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. Equity markets are volatile and an investor may ...

Health Care’s Outlook Clarifies

This article originally appeared in the October/November 2012 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.

When the U.S. Supreme Court upheld the individual mandate in a narrow ruling on June 28, a main hurdle for health-care reform was cleared, and with it, an uncertainty that hung over the sector. Now, health-care companies can focus on adapting to reform and overcoming their other challenges, such as pricing pressures, government cost-cutting, and the poor economy. To learn more about the outlook of the health-care sector, I sat down with Alex Morozov, director of the health-care analyst team at Morningstar, and Damien Conover, Morningstar’s director of pharmaceutical research. Our discussion took place Aug. 22.

Philip Guziec: The big news over the summer in the health-care sector was the U.S. Supreme Court ruling on the Affordable Care Act, otherwise known as Obamacare. We also have an election coming up in November. What do these events mean for the health-care sector?

Alex Morozov: The Supreme Court reaffirmed that the cornerstone of Obamacare—the individual mandate—is constitutional. We think that the ruling is the final chapter of the Obamacare debate. The November election could throw a wrinkle into the whole thing, but a perfect storm would have to occur for the Republicans to gain enough political advantage to repeal the act. In addition to winning the election for president, Republicans have to get filibuster-proof majority in the Senate. Right now, that looks like a long shot. Without gaining the presidency or an overwhelming majority in the Senate, Republicans could still find ways to tie up parts of Obamacare using budget maneuvers, but it’s a potential landmine for Republicans. Even though right now the public is split on Obamacare, many of its provisions have already been put into place. Once the public starts realizing the benefit of some of these provisions, restricting them is going to prove to be very challenging for Republicans.

So, at this point, we’re assuming that Obamacare will stand regardless, and what the individual mandate does for the health-care sector is that it allows companies to capture the upside of Obamacare. More than 30 million newly insured people will enter the health-care system.

Damien Conover: Another aspect of the November election is that no matter which party wins we expect a return of Washington’s focus on cutting the federal deficit.

One element that is very likely to happen, because both parties agree on it, is something that will have an impact on big pharmaceutical firms: coordinating the costs of dual-eligible patients. Currently, if a patient is eligible for both Medicare and Medicaid, he gets reimbursed at Medicare levels, which are about 30% higher than Medicaid prices. There is a lot of support to eliminate this difference. If it goes through, big pharmaceutical companies would take a 2% to 4% hit.

Dual-eligibles is just one area where the government will look as it returns its focus to cost-cutting initiatives. And again, this will probably happen no matter who wins in November.

Morozov: Another one of those areas that could see cuts is funding for government and academic projects. If the most-draconian measures are passed, the National Institutes of Health could face 7% to 9% cuts in its budget. Funding for new research would be slashed, which would be a major blow to life-science firms.

Guziec: If Obamacare is here to stay, give us a blow-by-blow of what health-care reform and 30 million newly insured people mean for the major health-care sectors?

Morozov: For medical technology and devices, Obamacare’s effect will not be that significant, because a lot of recipients of medical devices are already on Medicare. Also, these newly insured folks will be younger; they’re not the medical-device industry’s customer base.

That said, Obamacare is a big plus for diagnostic companies, health-services companies, and hospitals. Hospitals are probably the biggest winners. The individual mandate will allow them to finally limit the charity care that they’ve been providing for years for underinsured or uninsured patients.

Conover: In the pharmaceutical sector, we see reform as a net neutral. But it’s important to dissect that a little bit. The negatives of Obamacare for the pharmaceutical industry are front-end loaded, and then the positives kick in on the back-end. What I mean by that is that during the first couple of years of Obamacare, the big pharmaceutical companies are paying fees that are going to weigh on earnings in the range of 2% to 4%.

By 2014, however, we get this inflow of millions of people who weren’t insured. An insured person spends about 30% more on drugs than does an uninsured person. So, there’s this tailwind that comes in the latter part of the decade as Obamacare gets instituted. We think that this tailwind hasn’t been fully appreciated by the market. Hence, we still think the pharmaceutical industry is undervalued, even with their recent run-up.

Guziec: Alex, what about the excise tax that medical-device companies will have to pay?

Morozov: At 2.3%, it’s a meaningful headwind, but it’s not as punitive to the industry as one may think. If, on average, the medicaldevice companies carry margins somewhere from the high teens to mid-20s, it’s a sizable hit. But we do need to remember that most of the device companies are multinational, so that alone is a sizable offsetting factor to the tax. For companies like Becton Dickinson BDX, the tax is going to be less than $100 million, which ends up being somewhere in the 1% to 1.5% range, as opposed to 2.3%.

Also, a lot of medical-device companies have been restructuring their operations; they’ve been getting leaner ahead of the tax, because really the tax is just one of the many secular headwinds that the industry is facing. Pricing pressure is one; economic utilization is another. So, the excise tax, for many companies, is just yet another hurdle that they have to overcome. How do they do it? Mainly through focusing on emerging markets—on areas where they can leverage their technology and get new demand.

Guziec: Has the market priced in these lower expectations?

Morozov: Yes. Medical technology is one of few remaining undervalued sectors in health care. The market is seeing next year’s depressed earnings because utilization is still fairly weak and the excise tax is going to provide a decent hit to a lot of those companies’ earnings. But the market is dismissing very strong demographic trends and good growth prospects for a lot of these med-tech firms. It’s a sector we’re bullish on. Several firms have 4 and 5 stars. We’re bullish on Covidien COV, St. Jude STJ, Medtronic MDT, and Stryker SYK.

Guziec: Another big uncertainty is the economy. What do we see going forward with macro conditions and health care?

Morozov: I think it is the biggest question right now surrounding health care. Is this the new normal? Will people be more conservative with their health-care spending? What we saw in this past cycle was that people pulled back in their use of health care, and not just for elective procedures, but procedures that we didn’t think patients would delay or defer.

Employers are raising premiums for insurance plans and making deductibles higher. Higher deductibles mean higher out-of-pocket costs. Patients will have to ask the question, do I really need to go to a doctor now, or can I just postpone it again?

If this is the new norm, then the growth of health-care expenditures will probably get closer to the GDP growth. Health-care-cost inflation has been a couple percentage points ahead of real GDP, which has caused health care to grow to 18% of the total GDP. That cost curve could change.

Guziec: We’ve mentioned a few stocks, but what else do we like?

Morozov: Express Scripts ESRX is clearly one of the strongest companies right now in the health-care space. After its merger with Medco, it is the largest pharmacy benefit manager in the United States. The PBM space is very consolidated. There are only two major players now left, with CVS Caremark CVS being the other one. Because of its size, Express Scripts has very strong bargaining power, both over big pharma and other customers. So it’s one of our top picks in the space, trading at a fairly attractive price, about 20% to our fair value estimate.

WellPoint WLP is a 5-star stock in the managed-care space. This is a value story, as execution has been subpar for the company. It underperformed the entire managed-care space primarily because of the mishaps with execution. That said, WellPoint is one of two managed-care companies that has an economic moat, which stems from its massive membership. As a result, it has great scale. Scale is going to be the name of the game going forward, since managed-care companies’ ability to underwrite is going to be very limited in Obamacare. Scale allows companies to spread administrative costs over a large membership base, and WellPoint has the second-largest membership base. WellPoint is trading at somewhere around seven times forward earnings, which is a 15% to 20% discount to most of its peers. It’s trading at about a 35% discount to our fair value estimate.

We also like the medical-technology sector. A company I mentioned earlier, Covidien, is our top pick in the med-tech space. This is a company that emerged from underneath the Tyco roof a few years ago. Since then, management has done a stellar job of shedding some noncore businesses that the company carried when it was part of Tyco. This reversed a trend that many firms back in the day took of bringing non-related products under one roof and turning into huge conglomerates. Covidien went the other way and focused on the device area and invested a lot of research and development into its device space. Its R and D went from around 1% to 1.5% of total sales to 4.5% percent of sales, in a short four years—which has yielded a great number of new products. The company is going to be more or less a pure play device firm, once it completes a spinoff of its pharma unit, which is scheduled for early 2013. It’s trading at about 30% discount to our fair value estimate, and the market clearly underappreciates the earnings growth there.

Guziec: What about some pharma names?

Conover: In pharma, one industry that we haven’t talked about is contract research organizations, or CROs. One name we like in the space is Icon ICLR. This is an industry that’s benefiting from big pharmaceuticals’ patent cliff, which has caused firms to cut costs. Finding secondary ways to play major themes in health care is a great way to position investments. This is one of those types of plays. As pharmaceutical firms lose patent protection on high-margin products, they need to cut costs. One way that they’re doing that is outsourcing their research and development. Contract research organizations do this much more cheaply than the pharmaceutical firms, so they’re getting a tremendous amount of business. We think Icon’s one of the better positioned CRO firms out there.

Roche is a biotech name that we like. The firm has a high exposure to biologic products that have long duration of patents. These are the products that are not facing pricing pressure as much as other products in the pharmaceutical and biotechnology landscapes. It’s a wellpositioned firm that the market is undervaluing.

Pfizer PFE is a firm that we think is underappreciated for its ability to cut costs. Not only is it outsourcing some of its research and development projects to CROs, but it’s also cutting its sales force and streamlining manufacturing and adapting to its patent cliff, well ahead of what we think investors are anticipating. On top of that, Pfizer has one of the best positioned pipelines that it’s had in the past five years.

Guziec: There are some attractive yields in big pharma, especially in a low-rate environment.

Conover: That’s a really good point. In a current environment where yields are very difficult to find, the average yield of big pharmaceutical firms is close to 4%. And those are very stable dividends. It’s very unlikely that you’ll see a dividend cut from the big pharmaceutical firms. The payout ratio for the industry is approximately 40%; it’ll probably maintain that 40% payout ratio, while earnings will probably grow close to 2% to 3% over the next five years on a compound annual growth rate. You’re not going to see increases to the dividend that robustly but, nevertheless, there is very secure cash-flow generation.